2015 was a milestone year in mankind’s comprehension of the climate change challenge. At COP21 in December, every government in the world assented to the Paris Agreement on Climate Change. 2016, in contrast, provided the surprise US election result, and with it uncertainty over subsidies and US climate change goals.
Investors have always held concerns about policy risk in renewable energy – legitimately, in some cases – but we believe the basic direction of travel is now set. As costs continue to fall and economic fundamentals now compete with other forms of power generation, the importance of subsidy regimes is diminishing. Here we examine how long-term investors can take advantage of what could reasonably turn out to be one of the most significant structural growth opportunities of the 21st century.
Broadly speaking, government support has encouraged the rapid growth in renewable power over the past decade (see Figure 1), but it has also created volatility – both in project economics and in underlying market performance of the sector. European countries such as Germany deserve credit for supporting what started as a loss-making industry, but we have also seen governments offer unrealistic guarantees to maintain subsidies, feed-in tariffs and tax breaks to incentivise demand for renewable technologies. The clear challenge for governments is to develop sustainable policies for this sector. Renewable energy companies need long-term policy visibility to plan their projects and model their returns.
The US Department of Energy set a positive example of long-term policymaking in December 2015 when it announced a stimulus package for wind and solar investments with multi-year extensions of the 30 per cent Investment Tax Credit (ITC) for solar and the $23/MWh Production Tax Credit (PTC) for wind. These extensions include tapering the credits over set time periods: PTC tapers from 2017 to 2020 and ITC tapers from 2018 to 2022. The initial extensions are a welcome benefit and the set tapering of these subsidies should continue to incentivise significant cost reductions and technological improvements. We believe by 2020 these improvements will more than offset a full removal of these subsidies.
A maturing market: falling costs and improving profits
Stable global policy is important, but it is no longer the only driver. Around the world, renewable energy projects are competing with the other sources of power generation on a purely economic basis – excluding subsidies – as costs fall and profitability improves. The component costs used in wind and solar generation (such as panels and turbines) have fallen and efficiency has dramatically improved.
According to Bloomberg New Energy Finance (BNEF), the cost of a utility-scale solar panel fell by 68 per cent between 2009 and 2015, while the cost of onshore wind power fell by 50 per cent over the same period. As costs decline and renewable projects compete on a standalone basis, the stability of returns and profitability should improve.
The falling production costs also provide a good opportunity to evolve policy and remove support. Europe leads the way on these changes, with countries such as Germany removing tariffs and using competitive bidding to allocate to large-scale renewable energy. This is also becoming increasingly popular in leading emerging market economies. The auction market is driving healthy competition among bidders and pushing costs even lower.
Figure 2: Bloomberg New Energy Finance (BNEF) April 2016
Onshore wind levelised cost ($/MWh)
Solar PV Module Cost ($/W)
H2 2016 Levelised Cost of Electricity (LCOE)
Central and regional scenarios ($/MWH)
Source: Bloomberg New Energy Finance, 2016.
The industry’s transformation from an alternative, subsidy-dependent policy tool to a mainstream energy source is well on its way. The challenge for analysts and investors – and indeed policy makers – is to determine the speed at which the transformation advances from here.
The Trump effect: unlikely to derail the growing global movement
Investors and commentators across the spectrum are trying to understand which of Trump’s stated beliefs and electoral promises will make the transition from the campaign trail to the Washington policy agenda. Climate change and renewable energy are good examples of this. Given President Obama’s pre-eminence in the preparation for and implementation of COP21 in 2015, it would be a considerable setback if Trump were to undermine the Paris Agreement; the US has made huge advances since their refusal to ratify the Kyoto Treaty. Regardless of his negative commentary on the campaign trail, Trump recognises himself that “clean air is vitally important…”
In August 2015, President Obama and the Environmental Protection Agency (EPA) announced the Clean Power Plan (CPP), enacted to reduce carbon pollution from power plants while maintaining energy reliability and affordability. The CPP had many challenges to face even before Donald Trump’s victory – 28 states continue to wage legal action against the plan. However, the appointment of Scott Pruitt to lead the EPA undermines it further: Pruitt is an outspoken climate change sceptic and a clear opponent of the CPP. Of course, coal faces challenges beyond the confines of US policy makers: technological innovation and changing economics in gas and renewable energy are likely to erode its market share over time. Efficient combined-cycle gas turbines (CCGT) continue to be the cheapest electrical generation capacity to build in the US at US$1.01 million per megawatt (MW), with coal at US$2.49 million/MW, solar at $1.5 million/MW and wind at 1.85 million/MW, according to BNEF.
Turning specifically to the ITC and PTC, we believe Trump is unlikely to cut either. The extension was passed with bipartisan agreement and has important implications for Republican states. Notably, 65 per cent of wind power capacity in the US can be found within Republican territory. Furthermore, the credits taper off over the next five years and Congress is not accustomed to the retrospective withdrawal of tax credits. At the state level, local authorities have taken up renewable policies. For example, 43 states currently require utilities to buy excess power generated by consumers with solar arrays. The federal government would find it difficult to change this type of state policy.
The other interesting argument is around employment. If the President is fighting for the forgotten American worker he will know at least that the number of US jobs in solar energy overtook those in oil and natural gas extraction for the first time in 2015. Trump’s plans for significant infrastructure spending should also support the US Department of Energy’s Grid Modernisation Initiative. This would benefit companies that focus on smart cities, smart grids and networks, energy efficiency and electronics. Meeting his ambitious target of doubling US GDP growth will require a reliable and functional energy system.
Figure 3: There are more jobs in solar than oil and gas, coal extraction – in the US employment grew six per cent in solar and slumped 18 per cent in upstream oil and gas and support services
Source: International Renewable Energy Agency, US Bureau of Statistics. Bloomberg.
A Chinese takeover: leading innovation on a global scale
Policy on the future of Chinese renewables appears clearer. Not only is China now by some margin the largest market for renewable energy, but it now has an opportunity to take the leading role in the international community on this key issue. If the US reneges on its historic commitments, China will legitimately use this as a chance for its own global advancement. How quickly things have changed. China’s focus upon environmental policy goes beyond renewable power, reaching into many energy efficiency and sustainability projects. The government has committed to peak its emissions by 2030 and a large part of successfully achieving this target is through non-fossil fuel energy reaching more than 20 per cent by 2030. China’s 13th Five-Year plan also requires this share of non-fossil fuel to reach 15 per cent by 2020.
Despite a strong position, China has some considerable issues of its own to overcome. On the supply side, the growth in renewables has resulted in overcapacity and significant curtailment of renewable power. Clean energy produced in the North West simply cannot get to the high demand areas in the east of the country when needed. Lacking grid infrastructure and incentives to shift the electricity has slowed progress. Ultra-high voltage lines are being built to solve this problem and the government plans to open up the monopoly on the grid and electricity market. There will also be social impacts to resolve. For example, some local authorities have shown a preference for saving thermal power plants, recognising that plants burning fossil fuels provide a greater number of jobs. The social impact of the energy transition in China was clearly highlighted in the 13th Five-Year Plan: an estimated 1.5 million workers in the coal industry will be made redundant between 2016 and 2018.
However, given China’s desire to lead innovation on the international stage, in addition to its more urgent environmental problems domestically, we believe it will overcome many of these challenges allowing the renewables sector to prosper.
Looking to the future: an opportunity for long-term investors
The Trump victory introduces unwanted uncertainty at a critical moment for the renewable energy industry. It remains to be seen whether his published views on climate change will result in a change in US policy and commitment but the appointment of Scott Pruitt is an ominous sign. However, we believe there is now unstoppable momentum on a global scale that individual governments will struggle to derail. Falling costs, improving economics and broad-based public support will prevail, in our view.
The sector presents a tremendous opportunity for long-term investors. The winners in renewable energy, energy efficiency and electrification can expect to become leading global companies over the coming decades. The volatility and complexity in these sectors in public markets could present a compelling proposition for patient capital.
Tom Nelson is head of Commodities & Resources at Investec Asset Management. Graeme Baker is an analyst with Commodities & Resources at Investec Asset Management.